We’re presently engaged in a renewed national discussion about immigration, with proposals working through Congress to provide a path to citizenship for undocumented residents. The topic always raises passions, and sometimes, misunderstanding.

From an economic perspective, immigration has clear advantages, which are described below. But it will be terribly important for policy makers to consider new openings at both ends of the skill spectrum to reap the full benefit of immigration reform.

At present, the fraction of Americans who were not born in our country is at its highest level in almost a century. This places the United States at the upper end among major economies.

The vast majority of this group is here legally, but the focus of recent Washington discussions has been the 11 million undocumented immigrants (28% of the total) currently thought to be living in the US. The possibility of offering some of them an opportunity to become legal residents has raised questions about the impact this step might have on our economy.

It’s therefore a good time to reinforce understanding of some facts and figures in this area. Some highlights:

a) Illegal immigrants do pay taxes, and would pay more taxes if granted green cards. Undocumented residents pay sales taxes, property taxes (often through rent), and it is estimated that half of them pay income taxes.

Once on official payrolls, they’d be liable for payroll taxes and Federal income taxes. Further, studies show that legal immigrants earn significantly more for the same type of work than undocumented workers. So their contribution to the tax base would be even more significant.

b) Many studies suggest that those who have come here illegally initially absorb more in government spending than they pay in taxes. But this deficit tends to diminish over time as families become more settled. (Note that non-citizens are not eligible for the most significant social programs we offer: Social Security and Medicaid/Medicare.)

Incremental revenue generated from providing a path to citizenship would outweigh the cost of social services they receive. A study by the Congressional Budget Office in 2007 found that legalizing undocumented workers would add twice as much revenue as it would cost.

c) Adding prospective beneficiaries to our entitlement programs may not seem like the smartest thing to do, as we wrestle with the economics of those systems. But the immigration of younger workers actually helps that dynamic by evening out our country’s age distribution.

(Note: the old-age support ratio compares the volume of people over 65 with those aged 20-64.)

In this regard, we are much better off than China and Japan, and in somewhat better position relative to Western Europe.

d) Studies consistently suggest that immigration enhances living standards of existing American workers. Further, research also typically finds that immigrants rarely crowd native citizens out of jobs at either end of the income spectrum.

Much of the immigration discussion centers on low-skilled newcomers, but consideration should also be given to the other end of the spectrum. American universities are educating substantial numbers of foreign engineers and scientists, and many would like to stay in the US after graduating. Once here, they are much more likely to file for patents than natives are.

Current immigration rules limit their ability to become permanent residents; the number of visas for highly-skilled newcomers has actually been declining. As a consequence, the talent returns home, to the benefit of overseas businesses. Any immigration reform must include an increase in visas for well-educated entrants.

As before, the upcoming discussions on immigration will not be easy ones. But the rewards of reaching consensus could be substantial.

Will the US Labor Force Participation Rate Move Up Soon?

The labor force participation rate (LFPR) of the US economy has been trending down for more than a decade. There is range of opinions about this development, particularly regarding its influence on the unemployment rate in the recent recovery. Since changes in monetary policy in the months ahead are partly tied to a 6.5% unemployment rate, the LFPR could play an important role in determining the future course of interest rates.

In this context, let’s examine the recent trend of the LFPR and identify the underlying forces that may alter its future path.

By definition, labor force participation is the percentage of the non-institutional US population aged 16 years and older that is employed or actively looking for work. Participation rates vary greatly by age, gender, and ethnicity. For example, older workers are a smaller percentage of the labor force than prime-age workers; the male participation rate is higher than that of females.

In addition, the LFPR varies at different stages of a business cycle. Workers may drop out of the labor force during a downturn in economic activity, leaving the workforce to pursue retraining, and they could reenter the labor force as business conditions improve. The impact of all these factors on the LFPR in the post-war period is shown below.

It is worth noting that the magnitude of decline in the LFPR in the most recent recession and recovery is striking and has no historical precedent.

Three aspects stand out when the LFPR is examined by gender and age since 2000: (1) The size of the decline in the participation rate of men exceeds that of women, (2) the 16-24 age cohort has recorded a larger drop than the prime-age group (25-54 years), and (3) the 55 years and older group registered an increase in the participation rate.

The reasons for the decline in the LFPR for the working population vary. At one end, focus on academic achievements, competition from older workers, and fewer low-skilled jobs explain a large part of the very pronounced decline of the LFPR in the 16-24 age group. A rebound in participation among these younger workers is not considered very likely, as the skills required by many newly-created jobs will lead many to stay in school longer.

While older workers tend to have lower rates of labor force participation (attributable to availability of Social Security benefits), the tendency of this cohort to work has been rising. This is likely the result of longer, healthier life spans and economic needs that have been increased in the wake of the Great Recession. Many expect this trend to continue in the decades ahead.

The aggregate LFPR is determined by demography and cyclical forces, with the former playing a bigger role versus the latter. A translation of weak (strong) job prospects into a reduction (an increase) of the labor force is an example of how cyclical factors affect the LFPR.

The key question is if the LFPR, which has hovered around 63.6% in the last few months, will stage a turnaround soon. Even if the economy strengthens, an increase in the unemployment rate is conceivable if the LFPR advances. If it continues to trend down, the FOMC could be looking at a 6.5% unemployment rate sooner than currently expected.

For the LFPR to advance, the net impact of demographic and cyclical factors has to be positive. Population estimates can help to sort out likely demographic pressures. The demographic composition of the US economy is changing such that in the next few years the percentage of the working age population is projected to trend down gradually, while that of the older population is expected to move up.

Research from the Kansas City Fed concludes that roughly 50% of the decrease in the LFPR during and after the Great Recession can be traced to cyclical factors. In others words, as economic conditions improve discouraged workers should move back into labor force and the LFPR should increase.

Based on all this, the outlook for 2013 is that LFPR should post only a moderate increase to reflect the interplay of demographic and cyclical factors. While that will limit the potential for improvement in the unemployment rate, it certainly should not interrupt the declining trend of the last three years.

Bank of Japan’s Independence Remains an Open Question

Following the election of Shinzo Abe as the new Prime Minister, the Bank of Japan (BoJ) formally announced a 2.0% inflation target on January 22 that must be met in the “earliest possible time,” but noted it would commence open-ended asset purchases only in January 2014. The recent policy change is an aggressive step in terms of the inflation target but the size of asset purchases is deemed small.

While most think that the new monetary strategy is the right one, and long overdue, some are also uncomfortable that pressure from the Japanese government led to the BoJ’s new policy announcement. The current BoJ Governor announced his intention to step down early, which some attribute to political pressure. Two deputy governors will be replaced in March. It is widely believed that new appointees will be sympathetic to economic positions of Prime Minister Abe.

The sequence of recent events raises questions about the BoJ’s independence. Historically, the BoJ has never held the position as a premier independent central bank. The Japanese economic model has allowed for a collaborative interaction between its different economic and financial institutions.

In the press conference last month, the current BoJ Governor Shirakawa stressed the importance of a central bank’s independence. There is nothing mysterious about the merits of central bank independence. Economic theory and experience support the view that maintaining central bank independence and isolating it from short-term political pressure results in desired macroeconomic outcomes.

Monetary policy works with long lags, and pandering to short-term political objectives with monetary policy stimulus would have a destabilizing impact because the timing and magnitude of monetary policy action could be inappropriate. Eventually, it could translate into wide swings in the business cycle and destroy long-term prospects of an economy.

Political interference in monetary policy decisions damages the credibility of a central bank’s inflation-fighting credentials. Central banks are committed to maintaining price stability. If public perception is modified by the political ties of a central bank, expectations of inflation are altered to the extent that demand for higher nominal wages will prevail. The absence of central bank independence would translate into higher inflation and inflation expectations without improvements in output and employment.

It may be premature to conclude that the recent policy actions in Japan reflect an erosion of the central bank’s independence. The new team is not yet in place, so its actions cannot yet be judged. Further, reaching the new inflation target will require some coordination between the government and the central bank, since structural reform to support higher levels of economic activity will be required to reach the 2% goal.

Yet in a world where monetary policy has been unusually aggressive in stimulating economies, and where inflation targets are not just maximums, observers are worried that central banks may have crossed the line and compromised themselves. While Japan has been a recent focal point on this front, the actions of other countries also bear watching.